Changes to Rental Income tax charges

From 6th April 2017 there were changes to the rules on finance costs deducted against rental income. The changes only apply to residential properties held by individuals or partnerships; and not furnished holiday lettings.

Restrictions will be placed on the amount of deductions, so relief is only given at basic rate. This is being phased in over 4 years from 2017/18 to 2020/21 as per the table below:

Tax Year

% Fully Deducted

% Restricted to Basic rate of tax

2017/18

75

25

2018/19

50

50

2019/20

25

75

2020/21

0

100

How the tax reduction is calculated

The reduction is the basic rate (20%) of the lower of: –

Finance costs

Rental property profits (after using brought forward losses)

Adjusted total income (income after losses and reliefs and excluding savings and dividend income that exceeds your personal allowance.

The tax reduction cannot be used to create a tax refund.

If the basic rate reduction is calculated using the ‘rental property profits’ or ‘adjusted total income’ then the difference between that and the ‘finance costs’ is carried forward to calculate the basic rate tax reduction in the following year.

The following examples use the income tax rates and personal allowances for 2016/17:-

Personal allowance – upto £11,000

Basic rate (20%) – £11,001 – £43,000

Higher rate (40%) – £43,001 – £150,000

Example 1 – No effect on tax charge

Mr A has annual rental income of £52,000 and finance costs of £20,000. The rental property is his only source of income and it is assumed that the £11,000 personal allowance is deducted from profits prior to the tax being calculated.

2016/17

2017/18

2018/19

2019/20

2020/21

Fully deducted (%)

0

75

50

25

100

Rental Income

52,000

52,000

52,000

52,000

52,000

Expenses

(9,000)

(9,000)

(9,000)

(9,000)

(9,000)

Finance Costs

(20,000)

(15,000)

(10,000)

(5,000)

0

Profits

23,000

28,000

33,000

38,000

43,000

Tax @ 20%

2,400

3,400

4,400

5,400

6,400

Tax @ 40%

0

0

0

0

0

Finance costs

0

5,000

10,000

15,000

20,000

Less: 20% tax reduction

0

(1,000)

(2,000)

(3,000)

(4,000)

Total

2,400

2,400

2,400

2,400

2,400

The tax reduction for example in 2020/21 is calculated as 20% of the lower of: –

Finance costs (100% of £20,000) = £20,000

Rental property profits = £43,000

Adjusted total income exceeding PA = £32,000

The lowest amount is finance costs so £20k x 20% = £4k tax reduction.

As Mr A has remained as a basic rate tax payer the changes have had no effect on the tax he pays.

Example 2 – Increasing tax charge

Mrs B has self employed income of £35,000 and rental income of £18,000 with finance costs of £8,000

2016/17

2017/18

2018/19

2019/20

2020/21

Restriction (%)

0

75

50

25

100

Self Employed

35,000

35,000

35,000

35,000

35,000

Rental Income

18,000

18,000

18,000

18,000

18,000

Expenses

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

Finance Costs

(8,000)

(6,000)

(4,000)

(2,000)

0

Profits

8,000

10,000

12,000

14,000

16,000

Total Income

43,000

45,000

47,000

49,000

51,000

Tax @ 20%

6,400

6,400

6,400

6,400

6,400

Tax @ 40%

0

800

1,600

2,400

3,200

Finance costs

0

2,000

4,000

6,000

8,000

Less: 20% tax reduction

0

(400)

(800)

(1,200)

(1,600)

Total

6,400

6,800

7,200

7,600

8,000

The tax reduction for example in 2020/21 is calculated as 20% of the lower of: –

Incorporation of Rental Property portfolios

The new finance cost restrictions only effects individuals and partnerships, therefore by transferring the property portfolio into a company all the finance costs would become tax deductible and therefore in some circumstances incorporation can be relevant.

However, due to the changing dividend taxes, extracting income from a company is more expensive than it used to be, and so generally only larger portfolios will benefit from incorporation.

Things to consider when deciding whether to incorporate

Re-financing

Lenders will not allow the beneficial interest in a property to be transferred to a company without the mortgage being reissued in the company’s name. Company mortgages are likely to have a higher interest rate

Capital gains tax

Capital gains tax will be payable at the point of transfer as if a sale has taken place unless incorporation relief can be claimed. Incorporation relief allows the capital gain to be ‘rolled over’ into the base cost of the company shares, meaning CGT would not be payable on the property transfer. This can be claimed if:

The management of properties amounts to a ‘business’ which means the owners must be fully involved in the management of the portfolio

The business is being run to make a profit

Stamp duty land tax (SDLT)

SDLT would be payable when the properties are transferred to the company as the landlord would be a ‘connected party’ within the company. Properties transfer to the company at market value and SDLT is due on the transfer value. Note there is a 3% surcharge for homes which are not your principal private residence

However, where the transferor is a partnership, SDLT can be avoided. A partnership is defined as: –

Including at least 2 people who each own some property within the partnership, each file tax returns and each want to incorporate the portfolio eventually into a company.

A signed partnership agreement exists, which sets out the profit apportionment

Must be a genuine business with a profit motive and each partner actively involved in the business on a day to day basis.

When would incorporation not be advisable

Where there are cheaper and easier alternatives which get the investors after considering all costs and the ‘hassle factor’ largely to where they would be on incorporation e.g. selling off some properties, using a management or lease company, sharing property ownership with a spouse, buying additional properties within a company but leaving the existing portfolio personally-owned

Where the sheer re-financing cost (and cash required to pay down any mortgages to ‘fit’ the lender’s LTVs) for transferring a portfolio into a company isn’t justified compared to the tax saved

Where a portfolio is too small, or insufficiently profitable, or where the owner has a ‘day-job’ or significant non-property income, such that ‘passing’ the partnership and company ‘tests’ to enable the avoidance of CGT & SDLT is unlikely – this will mean potentially huge CGT & SDLT bills

Where an investor doesn’t have a large personal portfolio and can easily simply switch to buying future properties within a company

Whilst Moore Accountancy are unable to provide you with financial advice, hopefully the summary and explanation here will help you consider your existing portfolio and understand the implications of the interest charge which will affect your taxable income and tax due to HMRC on your next tax return.